Assumptions In The 401k Vs Real Estate Example
In this example, the rental property couple did better than the 401 couple. Real estate investment risks do exist. The rental property couple did take on more risk as rental properties cant be diversified. Also rental property is not passive, even if the I.R.S. treats income passively.
Final Thoughts On 401k Or Real Estate
There are many ways to save for retirement.
Ideally, you should invest both in real estate and your 401 for maximum diversification. If money is a constraint, read how to bump up your saving rate so you can obtain the benefits of both income-producing assets.
If you have to choose one, Id prefer maxing out my 401 since it involves no sweat equity. Many 401 plans include real estate investment trust as one of the options. This way you can have your cake and eat it too. Of course, REITs are a slightly different beast than directly owning a rental property.
If you desire the benefits of real estate but lack the knowledge, time, or skills to invest directly, you could consider real estate crowdfunding.
However, no one, including me, can tell you which investment strategy is the best fit for your financial situation, risk tolerance, and long term goals. Those are decisions you need to make for yourself.
The example I have included should provide an excellent framework to guide you. I would encourage you to use my model and run the numbers yourself. The assumptions I made might not hold for you. It might be possible in your area to find a better cash-flowing property. Or your 401 options are horrible, and you found out that there are lots of fees hurting your returns.
You could also follow the hybrid approach of investing in real estate with the 401 or IRA.
Traditional 401 Penalty Exceptions
A traditional 401 provides a tax deduction on contributions, and taxes withdrawals as ordinary income. Normally, early withdrawals are subject to a 10 percent penalty tax, but exceptions are available. Early withdrawals escape the penalty if they result from job separation after age 55, rollover into another retirement account, death, total disability, financial hardship, medical bills exceeding 7.5 percent of your adjusted gross income or substantially equal regular payments based on your life expectancy. Even if you meet one of these exceptions, it’s important to keep in mind that if you withdraw money from your traditional 401 to purchase a home or for any other reason, that money will still be taxed as income.
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Investment Property Mortgage Requirements
Mortgage lenders get to set their own requirements. And the guidelines for investment property loans are usually stricter than for a primary residence.
Though rules vary by lender, here are the broad guidelines you can usually expect to see for an investment property mortgage.
- Minimum down payment: Often 15%, though some lenders still require 20%. Youll get better rates with 25% down
- Minimum credit score: 680 with a 15% down payment 620 with 25% down
- Maximum DTI: This is your debt-to-income ratio. Typically, your non-housing debts should be no greater than 28% of your gross monthly income. And your total debts plus housing costs shouldnt exceed 36%. But some lenders are less strict, often allowing 36% and 45% respectively
- Cash reserves: Many lenders want you to have cash reserves that are sufficient for you to cope for six months without rental income
- Loan limits: Government-backed mortgages and conforming mortgages have limits on the amount you can borrow. These vary according to local home prices
- Documentation: Expect lenders to request two years of tax returns, two years of W-2s, and two months of bank statements at a minimum
In addition to your finances, mortgage lenders will also evaluate the property you hope to buy.
Using Your 401 To Buy A House: A Guide
If youve been dreaming of owning a home, youve probably imagined yourself cooking in the perfect kitchen or having a fenced yard for the dog. But making that dream come true requires an incredible financial commitment and the first step is to cobble together the cash youll need for a down payment and closing costs.
You may be wondering whether you should consider using the money in your retirement account toward the purchase of a home. Before you decide, you need to be aware that there are both financial and legal considerations to take into account.
Lets examine the pros and cons, and see whether using a 401 to buy a house is right for you.
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Can I Use My 401k To Buy A Second Home
If you withdraw money from your 401 to buy a home, you may be subject to a 10 percent tax penalty. In any case, there are several exceptions you may be able to use to avoid the penalty. Depending on your states income tax regulations, you may be subject to penalties, but withdrawals are not always subject to them.
You may be able to use your 401 to make a down payment on a home if you have one. Because you can buy a home with as little as 3% down or as much as 0% down, you are unlikely to need to draw on your retirement savings for a down payment. Borrowing money from your 401K- This is another option for obtaining funds for a down payment. 401 withdrawals are not subject to an early withdrawal penalty under IRS regulations. In most cases, 401 loans must be repaid over the course of five years. When you use the money to purchase a home, you may be able to pay it back over a longer period of time. If you are laid off or leave your current job while you have a 401-k loan, your repayment period shortens.
You should not withdraw or borrow from 401 retirement plans to make a down payment on a home. There is some temporary benefit to managing money, but the long-term effects could be disastrous. You should review your savings account to see if you can qualify for a mortgage based on it before withdrawing money from your retirement account.
Loan For Investment Property
A loan from your 401 can help you take part in a transaction that the IRS would prohibit. This may sound sneaky, but there are certainly times when such a transaction may be necessary. Regardless of the reason for the loan, however, you should understand how to take one.
The first thing you should do is find out if your plan permits personal loans. Not all financial institutions will allow this. with Royal Legal Solutions, you are in luck! We recognize that your account is built from your money and investment choices and respect that. If you need access to apersonal loan, we can help.)
If your plan allows for a personal loan, you will then need to apply for one. As the participant, you must apply for the loan the Trustee will then approve it. , you are both the participant and Trustee, so this part is easy.)
You should know that your loan is limited. You can request $50,000 or 50% of your entire account balance.
You dictate your repayment plan. With an amortized loan, your repayment schedule must be five years or less. Your repayments must be made regularly. This includes weekly, bi-weekly, monthly or quarterly payments. Your loans interest rate must be consistent with interest rates being applied to other loans.
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Are There Other Options
Certainly! We encourage you to talk to a New American Funding Loan Officer to learn about other Conventional loans and government-sponsored programs that could help you get into your new home.
Additionally, we offer a mortgage calculator that can help you begin thinking about your budget.
If youre in the market for a new home or simply want to discuss your financing options a first-time homebuyer, wed love to hear from you today!
Roundabout Prohibited Transaction Question:
While the solo 401k investment rules allow for promissory note investments, this transaction would result in a roundabout prohibited transaction because the rules do not allow for a transaction that is prohibited to be done indirectly. In other words, while your brother is not a disqualified party from a solo 401k investment perspective, if he were to turn around and loan those borrowed funds or other funds to you, the IRS would view as you essentially processing a promissory note from your own solo 401k which is prohibited. Dont confuse this rule with the solo 401k participant loan rules, though. To learn more about the difference between a promissory note investment and a solo 401k participant loan.
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Borrowing To Buy Land
Undeveloped land can be an attractive investment in some circumstances, but there are some things to consider: Unless you are able to rent the land out somehow, farm it or exploit the land for minerals, undeveloped land does not typically generate an income. It does, however, generate property tax liability. You must be able to make the payments, if any, on the mortgage for the land, pay your own 401 back with interest within five years, and pay the property tax bills at the same time.
Borrow Against Your 401k
Take the time to research loan regulations. You may be able to borrow up to half of your 401ks value, up to $50,000.
However, its important to note that if youre using funds outside of your 401k to make your purchase, you will lose those tax advantages. Another crucial thing: if you borrow against your 401k, the money must be repaid by the deadline.
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Make A Sizable Down Payment
Since mortgage insurance wont cover investment properties, youll generally need to put at least 20 percent down to secure traditional financing from a lender. If you can put down 25 percent, you may qualify for an even better interest rate, according to mortgage broker Todd Huettner, president of Huettner Capital in Denver.
A larger down payment gives you more skin in the game and therefore more to lose if the investment doesnt work out. That can be a powerful incentive, and a larger down payment also provides the bank greater security against losing its investment. If the investment goes poorly, youll lose your whole stake before the bank begins to lose any money in the property.
Rental Equity Line Of Credit
All right, so RELOC may not be a term, but its still a thing. Landlords can take out HELOCs against rental properties, rather than their homes, if they have enough equity.
As with mortgages, expect the interest rates and fees to be higher on credit lines against an investment property compared to a HELOC. Thats because the risk to lenders is higher, as borrowers are more likely to default on investment property loans than on their home loans.
You can also expect the maximum LTV to be lower, with RELOCs compared to HELOCs. That means that lenders will lend you less of the propertys total value, again because their risk is higher.
Remember that when you borrow money to invest, you need to make sure youll earn a higher return on investment than what youre paying in interest. That includes both your investment property mortgage and any loans for the down payment. Run the cash flow numbers in our free rental property calculator to forecast returns, monthly cash flow, and operating expenses.
Another option if you have equity in your home or other rental properties is cross-collateralization.
Wait, cross-collata-what?
Also known as a blanket mortgage, you can offer to let your new lender put an extra lien against your home or a different rental property, as additional collateral. Say you apply for a loan to buy a new rental property, and they require a 20% down payment . You dont have enough cash, but lets say you do have another property with $100,000 in equity in it.
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Downsides To 401 Loans For Home Buying
While youre paying back the 401 loan, you usually cant make new contributions to your retirement account. And that means your employer wont be matching contributions, either.
All told, you could miss out on five years or more of retirement contributions and five years of compound interest on those funds which will likely make a big dent in your savings later in life.
Qualified 401 loans are penalty free. But if you leave your current company or are laid off while you have an outstanding 401 loan, the repayment period shortens. In that case, youd have to repay the loan by that years tax filing date.
- For example, if you take out a 401 loan on October 1, 2022, then leave your job on December 1, 2022, your entire loan would need to be repaid by April 15, 2023
If your 401 loan is not repaid by its due date, the remaining balance is treated as a 401 withdrawal, meaning its taxable income and subject to a 10% penalty.
Special Mortgage Rules For Investment Properties
One of the advantages of buying an investment property is that you can typically add your anticipated rental income to your existing income when you apply. That will help you prove you can comfortably afford your new mortgage payments.
However, dont assume your lender will count all that extra income, nor that it will take your word for how much it will be.
Lenders typically allow 75% of the future rental income to count toward your qualifying income. And they require either a current lease agreement or a rental schedule, which will use the appraisers view of your likely rental income based on local comparisons with similar rental properties.
Youll likely need that extra income to qualify. Because your lender will want to be sure you can afford payments on your existing mortgage as well as your new loan.
When youre budgeting, also keep in mind that investment properties typically offer much more generous tax breaks than owner-occupied ones. So speak to your professional tax adviser to discover what those might mean to you.
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Invest On The Best Platforms
With real estate crowdfunding, you dont need to risk $100,000 or more to invest in commercial real estate. Instead, you can invest for much lower amounts such as $5,000. The best real estate crowdfunding platforms today are:
1) CrowdStreet, founded in 2014, is based in Portland and connects accredited investors with a broad range of debt and equity commercial real estate investments. CrowdStreet is great because they focus primarily on 18-hour cities with lower valuations, higher net rental yields, and potentially higher growth.
2) Fundrise, founded in 2012 and available for non-accredited investors. Ive worked with Fundrise since the beginning, and theyve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding space to take advantage of new tax laws.
Both of these platforms are the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals. Investors should carefully consider their own investment objectives when assessing the gamut of real estate opportunities that are available.
Using Your 401 Funds To Buy A Home Has Pros And Cons
Marcus Reeves is a writer, publisher, and journalist whose business and pop culture writings have appeared in several prominent publications, including The New York Times, The Washington Post, Rolling Stone, and the San Francisco Chronicle. He is an adjunct instructor of writing at New York University.
If you need cash for a down payment for a home, and you have a 401 retirement plan, you might be wondering if you can use these funds.
Typically when you withdraw funds from a 401 before age 59½, you incur a 10% penalty. You can use your 401 toward buying a house and avoid this fee. However, a 401 withdrawal for a home purchase may not be best for some buyers because of the opportunity cost.
Learn how to tap your 401 to buy a home and more about some alternatives for funding a home purchase, such as using a mortgage program or saving up cash.
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What Reasons Can You Withdraw From A 401 Without Penalty
You can withdraw money from a 401 without paying a penalty in these situations:
- Medical debt that exceeds a percentage of your adjusted gross income
- A permanent disability
- A court-ordered withdrawal to pay a former spouse or dependent
- Down payment for a first home
- You owe the Internal Revenue Service
- Death of the accountholder
- Income after your official withdrawal age
Do You Qualify For A Mortgage Without 401 Funds
With such a wide range of mortgageoptions and down payment assistance on the market, most people simply dontneed to tap their 401 in order to purchase a home.
On top of that, todays lowmortgage rates increase your home buying power by reducing monthly payments.Its easier to afford a home than ever before.
Before taking money out ofretirement, find out whether you qualify for a mortgage based on your currentsavings. You might be surprised.
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